Following the tax law changes made by the 2017 Tax Cuts and Jobs Act, many of our clients who are S corporation owners are getting advice to convert to C corporations or reading about possible advantages of doing so. This may not be such a good idea and needs to be considered very carefully.
The reason for this recommendation is that, under the 2017 act, corporate profits are subject to a new, reduced flat tax rate of 21%. But flow through income from S Corporations or LLC’s, and sole proprietor income, is taxed at individual rates. Individual rates can be as high as 37% (though most of our clients will not have the $600,000 in taxable income at which one hits that level). The federal income tax rate for married persons filing jointly is 22% for taxable incomes of up to $165,000, 24% up to $315,000, and 32% on taxable incomes from $315,000 to $400,000. In other words, the personal rate may not be much different from the corporate rate despite the change.
That said, in a corporation with large taxable profits the difference could be more significant, but the thought process does not stop there.
If one operates through a type C corporation to gain a tax rate advantage, the question then becomes, “how do you actually take cash out of the company for yourself, and what are the tax consequences of doing that?”
There are only a few ways to get the cash from your company, and they all have tax implications. You can take a salary (wages subject to payroll and income taxes), you can take dividends (which the company cannot deduct for tax purposes), you can take a payment for rent (but likely to be taxable income), or you can liquidate (subject to capital gain tax). These all involve some level of potential double tax on the same profits.
Before the 1987 tax act that drove most small businesses into S corporations or other nontaxable entities, we all operated in this environment with C corporations that were trying to get the best tax advantages given these problems. A switch back to C Corporations will revive the tax pitfalls that have more or less been forgotten since S corporations became the predominant choice.
For example, paying wages can generate a tax deduction to the corporation, but only if the compensation is “reasonable.” Anything unreasonable can be treated as a dividend (double tax again).
C corporations are also subject to a 20% tax on excess accumulated earnings, a punitive tax still on the books under Code § 531 that will come back to life with C corporations that accumulate earnings more than $250,000. If the idea of the C Corporation is to accumulate cash with a low current tax, at some point that strategy could lead you right into this tax, which can only be avoided (if at all) with careful planning and attention to detail.
Also, the new tax act has a complex deduction aimed at somewhat equalizing the tax rate for C and S corporations: the 199A deduction that can reduce the differential to less than 9 percentage points even in the worst of cases. As noted above, however, for most small businesses in Maine, even without that deduction the rate differential may be slight or nonexistent.
If the business does not anticipate any significant distributions from current profits, the tax reckoning might be delayed for many years and might be avoided by the strategies listed above. But it should not be overlooked in planning.
There are also possibilities the double tax can be escaped if the corporate shareholder dies owning the stock because the Code provides for a “stepped up” basis to date of death value. That means that the shareholder’s estate can sell the shares with no capital gain. But, of course, that does no good to a living owner who wants to reap the fruits of his or her labors while still alive.
Remember that, if you switch to a C corporation and then decide you want to go back to S, you normally have to wait 5 years, so you can’t pick and choose with any ease.
Our advice is to be aware of the implications of the new law, and look at your own circumstances. Be very careful if you get a recommendation to change over and be sure that all the consequences of the change have been considered. Run the numbers. Think about the long term.
We would be glad to discuss this with you or help in any way.
June 1, 2018
This article is not intended to be legal advice and you should not rely on the information herein as specific advice on any particular facts that you or your company may be dealing with. In the event you wish to explore this topic further, have questions, or would like to comment, please contact the author, Bryan M. Dench at 207.784.3200 or bdench@sta-law.com or reach out to any member of our team of taxation attorneys at Skelton Taintor & Abbott.